Mid-Year Warranty Report:

Numerous companies continue to fine-tune their warranty spending, reacting to claims rate fluctuations by modifying accruals. While warranty spending by one company can't be compared to another's, we can compare a company to itself over time, by way of a series of top ten lists.

Now that most American manufacturers have filed their second quarter financial reports with the U.S. Securities and Exchange Commission, it's time to see how the midpoint of 2007 compares to June 30, 2006.

By the middle of last year, we'd counted $13.8 billion in warranty claims spent worldwide by U.S.-based manufacturers. We think we're about 3% above that level in 2007, but that's just a guess, which includes some $2.7 billion in estimates.

It's possible there hasn't been much of an increase at all recently, just as claims in 2006 were up only 2.7% from 2005 levels. In other words, warranty claims are no longer soaring. For some companies, in fact, they're not even growing. As a percentage of sales, warranty claims are actually falling for many companies as the process becomes more efficient, as product quality and reliability increases, and sadly, as some warranty durations get shorter.

Top 100 Warranty Providers

Of the top 100 warranty providers during the first half of 2006 (as measured in dollars paid in claims), we now have 2007 warranty data for 81 of them. Six more will file their annual reports in September (for fiscal years ending on or about June 30), and the remaining 13 have for one reason or another failed to meet their obligations to file their warranty data quarterly.

Of the 81 that have filed their warranty data, 43 reported a lower claims rate (the percentage of sales revenue spent on warranty), 42 reduced their accruals rate (the percentage set aside to finance future claims), and 52 increased the size of their warranty reserve (the fund in which accruals are deposited), when these figures as of June 30, 2007 are compared to those from a year before.

For the other 19, we have most of the figures we need for June 30, 2006, but nothing to compare them to in 2007. And, except for the six whose fiscal years ended on June 30 (annual reports are usually filed 10 or 11 weeks after the end of the fiscal year, as opposed to five or six weeks for quarterly reports), there's no way of knowing exactly when that data will become available. The six for which we're too early are listed in Table 7. The 19 that are late are listed in Table 8.

The claims rates of the 50 largest warranty providers are all detailed at the top of the Warranty Week home page. Those companies are listed by their change in claims rate, from the largest annual reduction to the largest annual increase.

One company cannot easily be compared to another, because the exact components of their warranty accounting may differ. One company may include freight costs while another may not. One may assign a portion of its call center costs to the warranty account, while another may not. And so, comparing their percentages may create the false impression that the one with the lower percentages makes better products.

However, we have to believe that one company is consistent over time. Whatever definition of a warranty expense a company uses, we have to believe it remains the same from one quarter to the next. Therefore, when a key warranty metric changes, it doesn't do so because the list of components were changed. The percentage changes because something fundamental changes, such as sales volume, product quality, or future outlook.

Annual Comparisons

We can easily measure those changes, and compare them against one another. For instance, the Ford Motor Company has seen its warranty claims rate fall from 2.8% in the middle of 2006 to 2.5% in the middle of 2007. That's a decrease of 10%. A year ago, the claims rate at General Motors Corp. was just under 2.5%. This year it's just above 2.5%. And that's an increase of almost 2%.

What matters less is that both GM and Ford have claims rates around 2.5%. What matters more is that Ford cut its claims rate substantially over the past year, while GM kept its about the same, despite lengthening its powertrain warranties (though those expenses won't begin to appear for a few more years). Although Detroit-watchers are concerned about the future of both companies, at least in terms of warranty they're both in good shape.

What matters most in this week's exercise, however, is that Ford's 10% reduction was beaten by 25 other companies, including IBM, Hewlett-Packard, and Deere. Imagine that: 25 large companies have cut their claims rate by more than 10% in the past year. In fact, claims rates were cut by so much that even Eastman Kodak's 27% reduction wasn't large enough to make it into the top ten listed in Table 2 below.

Claims rate increases were equally abundant, however, and the top ten increases from midyear 2006 to midyear 2007 are listed in Table 1. This is not a list a company wants to make. Claims rate increases can be caused by falling sales volumes or rising incidents of product defects. It can mean falling product prices or increased repair costs. In one case, the claims rate increased because a company paid a $12 million bill late, shifting some 2006 expense to 2007.

Reasons for the Increases

None of the reasons for increasing claims rates are good, especially for these top ten. A slight increase is nothing much to be concerned about, especially if there's a side benefit such as longer warranties, better data for analysis, increased emphasis on warranties in marketing and advertising, and a buildup of customer goodwill. But a 135% increase? Something radical has changed.

For Tyco, part of the reason for such a mammoth claims rate increase is the structure of the company. Just before the end of the second quarter, Tyco spun off its healthcare and electronics operations into their own separate companies, leaving behind a product line that has a higher incidence of warranty expense than those it no longer controls. Product revenue fell from $16.8 billion in the first half of 2006 to $12 billion in the first half of 2007, while warranty expenses remained about the same. So there's a plausible explanation for the sudden rise.

Johnson Controls and Whirlpool can blame acquisitions for their claims rate increases. For instance, Johnson Controls, which makes auto interiors and other components, acquired an HVAC company whose products generate a much higher rate of warranty expense. So of course its claims rate is up 40%. It's a wonder it hasn't risen more. But what about the other seven companies listed in Table 1? Have they informed their shareholders of the reasons behind their rising claims rates? Most, we suspect, are hoping that nobody notices.

And then there are the claims rate decreases in Table 2. Semiconductor company Nvidia Corp. managed to cut its claims rate from 1.5% a year ago to 0.5% by the midpoint of 2007, thanks to a fortunate combination of rising sales and falling claims. Thanks to an acquisition, Thermo Electron Corp. became Thermo Fisher Scientific Inc., more than tripling its sales without much of a rise in warranty expense. Goodrich simply cut its warranty claims payments by 47% and saw sales rise modestly. And so on.

Looking Forward with Accruals

Readers who skim ahead will note that Delphi is also listed in Table 3 for a massive increase in its accrual rate, and again in Table 5 for a massive expansion of its warranty reserve fund. Why would a company whose warranty claims are shrinking turn around and start budgeting for a massive future increase? It's because claims are looking backwards while accruals are looking forwards. And Delphi sees some big claims coming down the pike from GM in the near future. As soon as those costs can be reasonably estimated, the company is accruing funds to pay them.

That's why we're including top ten lists for not only claims, but also for accruals and warranty reserves. Delphi is unique in that it's in the top ten on different sides. While seeing one of the biggest decreases in claims rates, it's also among the biggest boosters of accruals and reserves. Gateway, Medtronic, Nvidia, and Thermo Fisher also made it into three top ten lists, but for them claims and accruals were moving in the same direction.

Claims are what happens to you. Accruals are what you make happen. If you see claims rising, you would usually raise your accrual rate. If you see claims falling, you would check to see if a cut in the accrual rate is warranted. Usually, the accrual rate changes more gradually, because a company is putting aside a set percentage of current sales revenue to fund future warranty claims. So the accrual rate would only change if there is a change in the product mix or a change on product quality, or a change in expectations about future warranty costs.

The companies listed in Tables 3 and 4 are therefore signaling that a change is on the way. Notice that the top three companies in Table 3 are all in the automotive supply business. One could theorize that they see more claims coming their way in the future, thanks to increased supplier recovery efforts by the OEMs. But notice also that engine and construction vehicle manufacturer Caterpillar and ATV/snowmobile manufacturer Polaris Industries are also raising their accrual rates. And then there's Gateway, which is reacting to its 3.0% claims rate by boosting its accrual rate to 3.3%.

In other words, these increases make perfect sense. If claims are rising, accruals should also. And then there is the opposite case. If claims are falling, and if it's not totally due to sales increases (in other words, the frequency of defects and/or the cost of repairs are also falling), then a reduction in the accrual rate is also justified. If a company sells off a division responsible for high warranty costs (as Kodak did with its medical equipment operation) then there's good reasons to lower accruals afterwards.

Interestingly, however, only 29 of the companies that cut their accrual rates also saw their claims rate fall. Thirteen others cut their accruals in the face of rising claims. For some, it made no sense at all. For instance, United Technologies saw its claims rate increase 15% yet it cut its accrual rate by 43%. And several of the homebuilders we profiles in the August 8 issue continued their unusual behavior into the second quarter as well.

Again, accrual rates are entirely within the power of a company to raise or lower. Claims are what happens to you. Accruals are what you make happen. So the companies listed in Tables 3 and 4 are there because they chose to modify their accrual rates by more than their competitors. We're not saying any particular accrual rate is the best. What we're saying is that radical changes -- particularly radical decreases -- demand radical explanations. And "we need to report higher profits by manipulating accruals" is not an excuse we're likely to hear, at least not in public.

Measuring the Warranty Reserve Fund

The warranty reserve fund balance is a third measure of warranty expense. As deposits (accruals made) and withdrawals (claims paid) rise and fall, the reserve balance expands and contracts accordingly. Again, there is no one correct balance. Or to put it a different way, a given company's warranty reserve should always be the correct size for that company, given its product mix, warranty duration, failure rate, repair cost, etc.

So if these 81 warranty reserves were the correct size a year ago, and if they're also the correct size now, then the change in the balance must reflect the rising or falling fortunes of a company's product line, right? If sales are rising, there's more product in the field, and probably more repairs. Therefore, the reserve needs to expand. If a company sells off a whole division, that product line's warranty expense probably goes with it, therefore the balance should fall.

In Table 5, we're listing the ten largest percentage increases in the warranty reserve balance. For instance, Delphi boosted its reserve balance from $241 million on June 30, 2006 to $476 million on June 30, 2007. That's because in June 2007, Delphi announced that it expects to pay GM up to $199 million for defective catalytic converters and instrument clusters. And so in anticipation of those claims, the company has boosted accruals, and inevitably, its warranty reserve balance.

Oshkosh boosted its warranty reserve primarily because of the acquisition of JLG Industries at the end of last year. And although it didn't make the top ten list, it also boosted its accrual rate. Others expand their warranty reserves because they are launching new product lines for which the warranty cost is uncertain. Better to be safe than sorry, and better to have more in the bank than you need than not enough.

Reserve Fund Reductions

Which brings us to the ten companies in Table 6. As mentioned, companies such as Tyco and Kodak can point to recent divestitures as the reason behind their shrinking warranty reserve fund. Since they no longer sell those products, they no longer hold those accruals in their warranty reserve. Ingersoll-Rand also has a recent divestiture to point to, and IBM can say it is also still adjusting to a post-divestiture environment.

But what will the other companies say? AMD, for one, cited lower sales volumes and therefore fewer new warranties issued as justifying its reserve reduction. The problem with that logic, however, is that while AMD used to set aside $9.08 per $1,000 in sales, it now sets aside only $4.60 per $1,000. If it were just a matter of fewer sales requiring lower accruals, the rate per $1,000 would have remained the same. Claims, in fact, were $17.7 million during the first half of 2006 and $18.0 million during the first half of 2007. And sales actually grew from $2.55 billion to $2.61 billion over the same period.

It doesn't help AMD's case that the company switched from net profit to net loss at just around the same time as it found a need to cut accruals and contract its reserve fund. As with some of the homebuilders profiled last week, sometimes the need for cash is much higher on the list of reasons for a change in warranty estimate than a company lets on. The difference is that now they need to justify it publicly, because shareholders will notice.

As mentioned, there are six companies that ended their fiscal years on June 30. Six weeks after the end of their fiscal years, none have yet filed their annual reports with the SEC, nor are they expected to do so before September. We could wait four or five more weeks, or we could go with the data we have now and come back later with a revision. We decided upon the latter course.

Readers can therefore expect that if they come back and look at this story online in late September, the table below will be gone and these six companies will have joined the other 81 detailed above. Until then, we're going to simply list annual comparisons for these six companies for March 31, 2006 to March 31, 2007.

The same stories told above also weigh on these companies. Seagate is absorbing an acquisition of a company that has higher warranty costs. Harman paid an old $12 million claim in 2007, so this year's total is higher than it should be, and past years have been lower than they should have been. Sun continues to incrementally reduce its warranty expenses -- nothing dramatic, but always progress. Western Digital is reducing expenses despite longer warranty durations. And so on. There's no news in this small bunch.

Late Filers and Annual Filers

The more newsworthy stories will undoubtedly come out of some of the companies listed in Table 8. Unlike Table 7, where we're early, those in the table below are late, or have decided to take themselves out of the loop.

There are three kinds of companies in Table 8. The most numerous are the annual filers -- a list that includes Black & Decker, Eaton, General Electric, Goodyear, Illinois Tool Works, and Motorola. Despite clear language in the Financial Accounting Standards Board's regulations mandating warranty disclosures in all annual and interim financial statements, these six companies have decided to do so only once a year. Therefore, while we have good data for all of 2006, we have no data for 2007. And our estimates for the middle of 2006 are merely extrapolations of that annual data.

The second type of company in Table 8 is the late filer. Beazer Homes is late with one quarterly report, which helped spawn false rumors that it would be seeking bankruptcy protection. Dell is now late with four and soon five reports as a result of an accounting investigation that has now dragged on for two years. Navistar International has missed the deadlines for seven quarters, so we don't even have 2006 data to compare with. And UTStarcom is now late with its fourth quarterly report in a row (one of them would have been its 2006 annual report).

Former Filers

The third type of company is the former filer. Incredibly, the financial managers of Exide Technologies, Honeywell International, and Xerox have decided they will no longer include any warranty data in their Form 10-Q or Form 10-K filings. Exide last included warranty data in its annual report for the year ended March 31, 2006. Honeywell has omitted warranty data from its last two quarterly reports. Xerox ceased including warranty data at the end of 2005.

All three companies steadily reported warranty data before they decided that FASB Interpretation No. 45 rules no longer applied to them. That is to say, they issued product warranties and maintained a warranty reserve -- and still do -- but now they have decided it's nobody's business how much they're putting in or taking out. One can only hope that after the SEC is done investigating Dell, they'll give these companies a ring.

By the way, both the annual filers and the former filers are still sending their quarterly Form 10-Q reports to the SEC. They just don't include any warranty data. It would be up to the SEC to enforce those rules, but if it's taken the agency two years to investigate just Dell's accrual methods and there's still no conclusion (let alone an explanation), imagine how long it would take to go through this list. Bottom line: nothing is likely to happen until there's a new administration elected and a new SEC chairman takes office in January 2009.

Estimates for the Half Year

The absence of data for 19 of the top 100 warranty providers makes it extremely difficult to size the total for all manufacturers. We've been inserting estimates for each company, but in some cases we're now comparing last year's estimates to this year's estimates. With all those estimates included, we're eyeballing a top 100 that has spent $12.7 billion so far in 2007 on warranty claims, up from $12.3 billion last year.

There are an additional 600 or so warranty-reporting companies, of course, and along with these hundred, they've reported around $14.2 billion in warranty claims so far in 2007. That's just a slim 3% above the $13.8 billion in claims that was reported by this point last year. But as we mentioned, there are numerous estimates built into that total, so don't be surprised if these totals change.

For the first time in five years, Warranty Week is going on a summer vacation! Because of this shut-down for summer holidays, there will be no newsletters published for the next two weeks, though we will continue to update industry headlines and other sections of the Web site. We look forward to returning to our weekly newsletter schedule on September 4.